Saturday, August 3, 2013

High P/E Stocks are like Dosas in the Malls...!!

Consider a small restaurant in the city. What would be the cost of a Dosa? Let us assume it would be around Rs.20-30. The restaurant manages to make around 20-25% profit margin on each dosa, after deducting all costs.

Now, let us consider the same dosa sold at a food court in a swanky mall. The cost of each Dosa would be around Rs.80-100 (almost 200% higher). The restaurant manages to make only the same 20-25% profit margin.

So, why both make the same margins in spite of the huge difference in the pricing?
It is simple. The costs involved are much higher in the food court and hence, he charges more than what the small restaurant charges.

So, is this justified? I feel, yes...!! People are aware of this huge price difference in the dosa, but still you can see the malls crowded all the time, especially on weekends. The food courts never run out of business. They are making good volumes in spite of the premium pricing. My point is, people are willing to pay this premium price for the dosa at the mall.

This is similar to some of the high P/E stocks, especially in the FMCG sector.
They have always remained expensive in terms of Price to Earnings ratio. Does that mean that people investing in these companies do not make money?
Ok, here is a small analysis.

The markets have seen both bull and bear phases over the last ten years.
I have tried to compare the yearly returns (for the past 10 years + 2013) of 12 top listed FMCG companies with those of the Sensex.

Let me share with you my observations based on this analysis.
  • The highest return delivered by Sensex was 81.03% - in 2009. This year was quite positive for the markets as the Sensex recovered from the historic fall to 8,000 points. But, this 81.03% was not even in the top quartile when compared to the FMCG stocks. 3 out of these 12 companies delivered more than 100% returns in the same year.
  • The lowest return delivered by the Sensex was -52.45% - in 2008. During the same year, FMCG stocks were more resilitent to the fall, with the lowest return of -47.35%, generated by Gillette India Ltd.
  • As you can see in the chart, the FMCG companies on an average have delivered more number of top-quartile returns than the Sensex, less number of bottom-quartile returns than the Sensex.
This analysis reveals that in spite of the high P/Es, FMCG stocks have been resilient to falls and have delivered superior returns during bull markets.

Investors are willing to pay a premium for such stocks, like those willing to pay for the expensive dosas at the malls. Apart from superior performance, these companies have delivered consistent ROEs, Margins and Growth.

So, I believe that the high P/Es in such companies are justified...!!

Please share with me your views, folks.